ERISA Section 404(c): Shifting Fiduciary Liability In Participant-Directed Retirement Plans

By C. Frederick Reish and Bruce Ashton

By far, the most popular retirement plans in the 1990s have been 401(k) plans with participant-directed accounts. Part of that popularity is a result of extensive marketing by financial institutions such as mutual fund companies, stock brokerage firms, insurance companies, and banks that sponsor investment products. 401(k) plans appeal to employers because they (1) increase employee involvement in retirement plans; (2) transfer part or all of the cost of funding the plan to the employees; and (3) transfer investment responsibility to the employees.

Unfortunately, most companies and their officers and directors do not understand that some fiduciary responsibility—and potential liability—cannot be transferred. Also, many companies inadvertently fail to take the steps necessary to transfer responsibility for investment direction to the employees, leaving plan fiduciaries exposed to personal liability for employee investment losses.¹

Transferring Investment Responsibility
There are two reasons why companies often fail in their efforts to transfer fiduciary responsibility to the employees to the extent allowable. First, the responsibility for choosing and monitoring the investment options—as opposed to participants choosing among a pre-selected menu of investment options—cannot be transferred to the employees. Therefore, someone other than the employees chooses the investment options offered by the plan. This decision maker—the board of directors, a plan investment committee, an officer of the company—is the “responsible fiduciary.”² In selecting the investment options, the responsible fiduciary must act “prudently” and is liable for losses resulting from an imprudent decision.³ Second, to effectively transfer responsibility for selecting among the investment options, the plan must follow specific rules. These are found in the DOL Regulations under ERISA Section 404(c).⁴

Fiduciary Compliance
In addition to the initial selection of the investment options, the responsible fiduciary must monitor the options to ensure that they continue to be a prudent choice for the plan.⁵

What is prudent? The legal requirement for prudence under ERISA is for a fiduciary to discharge its duties with, among other things, “the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims....”⁶ This is sometimes referred to as the “prudent expert” rule, because ERISA requires that the fiduciary act not just with prudence, but with the prudence that someone “familiar with such matters” would exercise.⁷

As a practical matter, prudent in this context means selecting investment options that are expected to perform reasonably well relative to other similar investment products and against appropriate standard indexes. For example, if the investment options are mutual funds,⁸ prudence does not mean that the responsible fiduciary must pick the outstanding fund in every investment category or must constantly switch funds looking for the best performer. It does mean periodically (e.g., annually) reviewing how each fund has performed historically relative to other funds and benchmarks, and making changes when appropriate. If the fund has performed in the top half of its group of similar investments, there has been no change in fund management, and there are no other factors indicating that past performance was the result of unusual factors, it is probably safe to assume that the fund will continue to perform reasonably well in the future.

In fulfilling the duty to monitor the investments, the responsible fiduciary—the board of directors, a plan investment committee appointed by the board, or one or more company officers—should review the performance of each fund at least annually against a comparable index of performance. The fiduciary should look to see if each fund compares favorably to the performance of other funds of the same type and with the same investment objectives (using, for example, a commercial service such as Morningstar or Lipper). For instance, the fiduciary might use the S&P 500 Index to judge the performance of a large-cap equity fund. A small-cap equity fund could be compared with the Russell 2000 Index.

The responsible fiduciary should determine whether the funds have a poor rate of return relative to other similar funds and in relation to the appropriate benchmark or index. If so, the fiduciary should consider switching funds, and at some point, a prudent fiduciary will be obligated to switch funds.⁹

Conducting these comparisons is not sufficient, however. The fiduciaries need to keep minutes of the meetings at which they conduct their review. The minutes should reflect the alternatives considered and why they were chosen or rejected. Also, copies of the materials reviewed at the meeting should be attached to the minutes. If these steps are taken—prudent selection of the investment options, compliance with the requirements of ERISA Section 404(c), and proper monitoring of the investments—the fiduciaries should avoid liability for any losses suffered by the plan participants on the investment options that the participants select.

COMPLIANCE
Employers are typically told that they must do only three things to comply with Section 404(c): (1) give the employees three investment options; (2) let the employees make their own choices among the investment options; and (3) let the employees change the investments at least every three months. But depending on how the actual requirements of the Section 404(c) Regulations are counted, there are actually 20 to 30 different conditions that must be met (see Sidebar, page 176).¹⁰

Most mutual fund companies, stock brokerage firms, insurance companies, and banks have established procedures to assist the plan fiduciaries in complying, but there are some steps that the fiduciaries themselves must take. One of the most commonly overlooked is the requirement to tell the participants that the plan intends to comply with Section 404(c) and that the fiduciaries will be relieved of liability for investment losses. This can be done in the summary plan descriptions (SPD) or in another written notice to the participants. The plan document and related materials are often generic, pre-printed forms. Unless one of the employer’s advisors makes sure that the documents contain the right language to comply with ERISA Section 404(c), the protection is not available to the plan, the company, or the fiduciaries.

Another common error is the failure to offer confirmations to the participants when investment choices and changes are made. Some investment vendors provide these confirmations automatically, but many do not. If the investment vendor does not provide confirmations as a matter of routine, the plan fiduciaries must tell the participants that they have a right to request confirmations. Failure to advise the participants of this right will result in loss of Section 404(c) protection.

Although ERISA Section 404(c) compliance is complicated, employers should seek to meet its requirements. In this regard, Section 404(c) is like an insurance policy. When buying insurance, the analysis is whether the premium cost is worth the protection. Here, the question is whether the cost of compliance is worth the relief from liability that Section 404(c) provides. The answer clearly is “yes.” First, it is not expensive to comply (although the employer must give clear directions to its advisors regarding whom is responsible for each piece of the compliance puzzle). Second, the protection is valuable because the liability for investment decisions can be substantial.

The key to Section 404(c) compliance is to set up the program correctly in the first place. But for those who already have a participant-directed arrangement, some consulting firms and law firms have developed programs to help employers “self-audit” for Section 404(c) compliance. The cost of such an audit is outweighed by the benefit of Section 404(c) compliance.

Investment education. As participant-directed 401(k) plans have grown in popularity, employers have become increasingly concerned about their employees’ ability to make educated investment decisions for their retirement funds. As an outgrowth of this concern, employers have turned to a variety of vehicles for investment education, including employee seminars, newsletters, and retirement counseling. Until June 1996, however, investment education was inhibited by a concern among employers that if too much (or incorrect) advice was given, the individuals providing the investment education—e.g., the human resources director or other officer of the employer—might become a fiduciary and, as a result, assume liability for its employees’ investment decisions.

On June 11, 1996, the DOL issued Interpretive Bulletin 96-1, “Participant Investment Education,” which allayed employers’ fears by clarifying that investment education could be provided to employees without fiduciary liability, as long as the information was general (that is, did not specify particular investments) and the providers of the education were prudently selected and monitored. Broadly stated, investment education (as opposed to “investment advice”) can cover (1) plan information; (2) general financial and investment information; (3) asset allocation models; and (4) interactive investment materials. Interpretive Bulletin 96-1 goes into considerable detail in defining each of those categories. There are no surprises in the details, perhaps other than the constant reminder to avoid recommendations of specific funds or investments.

Is investment education required under the law? There is a common misperception that investment education is required under Section 404(c) to transfer investment responsibility and liability to the employees. There is no such requirement. In fact, footnote 1 to the Interpretive Bulletin states:

The section 404(c) regulation conditions relief from fiduciary liability on, among other things, the participant or beneficiary being provided or having the opportunity to obtain sufficient investment information regarding the investment alternatives available under the plan [such as prospectuses] in order to make informed investment decisions. Compliance with this condition, however, does not require that participants and beneficiaries be offered or provided either investment advice or investment education, e.g., regarding general investment principles and strategies to assist them in making investment decisions. 29 CFR Sec 2550.404c-1(c)(4).

The investment vendor (i.e., the mutual fund or insurance company) frequently will provide limited investment education services to a company’s employees as part of its basic contract. This could include, for example, employee meetings, newsletters, and asset allocation models. More comprehensive education and planning services are available from consulting firms. In addition, new businesses are emerging specifically to serve this market through, among other means, classes, seminars, video materials, and interactive computer programs. These developments represent the birth of an industry designed to serve the investment and retirement needs of the 401(k) market.

CONCLUSION
If adequate investment education is provided, the potential for fiduciary liability should, as a practical matter, be limited. Further, if the ERISA Section 404(c) rules are satisfied, 401(k) sponsors should have a defense to employee claims—so long as the investment options are properly selected and monitored.

ERISA SECTION 404(C) CHECKLIST

ERISA Section 404(c) applies to individual account plans, specifically:

• Profit sharing plans.
• Money purchase pension plans.
• 401(k) plans.

• The participants actually exercised control with respect to the transaction.
• The losses were directly and necessarily a result of investment instructions given by the participants.

• Only certain participants may exercise control (assuming this is not discriminatory).
• Participants may exercise control over only a portion of their account balance.

REQUIREMENTS
The opportunity of plan participants to exercise control requires that they may give investment instructions by any means but must have the opportunity to receive written confirmation. Those instructions must be given to an identified plan fiduciary who is obligated to comply and may be identified by position or function. Moreover, the fiduciary must give certain information to the participants.

Information that must be provided. The information must be generally sufficient to enable the participant to make informed investment decisions. Information that must be provided includes:

1. An explanation that the plan is intended to be a 404(c) plan.
2. An explanation that the fiduciaries may be relieved of liability.
3. A description of each investment alternative available under the plan, which can be general when the plan permits any investment, but should encourage participants to review information on the investment.
4. Each designated alternative must include a general description of the investment objectives and risk and return characteristics, and information regarding the type and diversification of assets in the portfolio of the designated alternative.
5. The identity of any designated investment manager.
6. An explanation of the circumstances under which participants may give investment instructions including limitations on such instructions; restrictions on transfer; limitations on voting rights; and information on penalties or adjustments related to fund transfers.
7. A description of transaction fees and expenses chargeable against the participant’s account.
8. Information on indemnification of the plan fiduciary responsible for giving information on request.
9. Information regarding investments in employer securities including a description of the procedure to provide for confidentiality and the identity of the fiduciary charged with monitoring compliance with the confidentiality requirement.
10. A copy of most recent prospectus provided to the plan if the investment is subject to the Securities Act of 1933 (this can be given immediately before or after investment).
11. After investment, participants must be provided with plan materials related to the exercise of voting, tender, or similar rights. If there are plan provisions regarding the exercise of such rights, participants must receive a description of or reference to such provisions. While the plan is not required to pass through such rights, Section 404(c) relief is not available to the extent that plan fiduciaries exercise the rights.

1. A narrative of the annual operating expenses of each designated investment alternative, including investment manager fees, administrative fees, and transaction costs, which reduce the rate of return to the participant. The aggregate amount of such expenses must be expressed as a percentage of average net assets of the designated investment alternative. If the information is already in the prospectus, providing the prospectus is sufficient.
2. Copies of prospectuses, financial statements and reports, and other materials related to the investment alternatives to the extent the information is provided to the plan.
3. Regarding the designated investment alternatives: (a) a list of assets comprising the portfolio of the alternative that includes plan assets and the value of the assets, and (b) if the asset is a fixed rate investment contract, the name of the issuer of the contract, the term of the contract, and the rate of return on the contract.
4. The value of shares or units and past and current investment performance of each available alternative, net of expenses.
5. The value of the shares or units held in the particular participant’s account.

Carrying out investment instructions. The plan may impose a reasonable charge for carrying out investment instructions so long as it has a procedure to inform participants periodically of the actual expenses incurred with respect to their accounts. The fiduciary may decline to follow instructions that would result in a prohibited transaction, or would generate income taxable to the plan (UBTI). The fiduciary is not relieved of liability when a participant instruction, if implemented, would:

1. Not be in accordance with the plan document.
2. Cause the indicia of ownership of plan assets to be outside the U.S.
3. Jeopardize the plan’s tax qualified status.
4. Plausibly result in a loss in excess of a participant’s account balance.
5. Result in a prohibited transaction.

Frequency of giving instructions. Participants must be given the opportunity to change their investments as often as the volatility of the investment requires (“general volatility rule”). They must be able to change core investment alternatives at least every three months, subject to the general volatility rule (“core” investments are those that constitute a broad range of investment alternatives).

If any investment alternative permits changes more frequently than once every three months, at least one core investment must permit the same frequency of change, and the investment into which participants can transfer must be income producing, low risk, and liquid. Non-core investments are not subject to the three month requirement but are subject to general volatility rule.

“Broad range of investment alternatives” requirement. This requirement is met if investments are sufficient to permit participants a reasonable opportunity to materially affect the potential return and degree of risk on their investments. The participants must also have an opportunity to choose from at least three investments that:

• Are diversified.
• Have materially different risk and return characteristics.
• In the aggregate, enable the participant to achieve aggregate risk and return characteristics at any point within the range “normally appropriate for the participant.”
• Each of which, when combined with the other alternatives, tends to minimize, through diversification, the overall risk of the portfolio.

ENDNOTES

¹While this column discusses fiduciary liability for losses, it is possible that participants could be financially “injured” by insufficient gains. See, e.g., Thomas Head & Greisen Employees Trust v. Buster, 24 F.3d 1114 (CA-9, 1994).

²ERISA § 3(21).

³ERISA § 404(a)(1)(B).

⁴DOL Reg 2550.404c-1. See also, Perdue, “ERISA Liability of Fiduciaries and Plan Service Providers Is a Growing Concern,” 2JTEB 19 (May/Jun 1994), and Jenkins, “Fiduciaries of Participant-Directed Accounts Must Plan to Protect Themselves,” 2JTEB 116 (Sept/Oct 1994).

⁵See, e.g., Hunt v. Magnell, 758 F.Supp. 1292 (DC Minn., 1991). (The fiduciaries to a plan include anyone who possesses or exercises discretion or control over the assets or administration of the plan. ERISA § 3(21). This means, for example, that a company’s chief financial officer can be a fiduciary to the plan by selecting the plan’s investment options or by making a change in those options.)

⁶ERISA § 404(a)(1)(B).

⁷For an indication of the factors considered important by the DOL, see DOL Reg. 2550.404a-1. See also Brodie and Glatter, “With Proper Planning Claims Administrators Can Avoid Unforeseen ERISA Fiduciary Responsbility,” 5JTEB 130 (Sept/Oct 1997).

⁸In the author’s experience, most participant-directed plans typically have five to eight funds, including a money market or other stable value fund, a bond fund, a growth and income fund, a capital growth fund, an aggressive growth fund, and an international stock fund. In addition, larger plans often offer guaranteed investment contracts. (GICS).

⁹See, e.g., In Re Unisys Savings Plan Litigation, 74 F.3d 420 (CA-3, 1996), for a discussion of the fiduciary’s role in the ERISA section 404(c) context.

¹⁰DOL Reg 2550.404c-1.

¹¹See, e.g., “401(k) Plans: Employer Practices and Polices,” Buck Consultants publication (1996).

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